Shares of Alphabet (GOOG) (GOOGL) collapsed around 10% this week. The company reported strong earnings for the third quarter, but apparently, investors were not pleased. Compared to competitor Microsoft, Alphabet posted weak growth in its smaller cloud computing division, which has some investors skittish.
It was hard to find any other concerns for the Google parent with this quarterly report, though. Its advertising units are starting to hum again and have a long runway to grow. Its profit margin is inching higher. Is now a good time to scoop up some Alphabet shares? Let’s take a closer look.
Advertising growth is back
The headline from Alphabet’s third quarter was accelerating growth in its advertising divisions. The most important of these is Google Search, which still generates the vast majority of the technology giant’s sales.
Google Search revenue grew 11.3% year over year in the third quarter, hitting a staggering $44 billion in just three months.
A much smaller but still promising unit is YouTube, the leading internet video platform. Advertising at YouTube grew 12.4% year over year to $7.9 billion in the quarter after stagnating for a few periods.
This is a great sign for Alphabet, as YouTube is supposed to be one of its top growth drivers this decade and beyond.
However, this YouTube advertising revenue may be understating the true growth of the division. In recent years, YouTube pivoted its strategy to focus more on various subscription offerings like YouTube Premium, YouTube Music, and YouTube TV. The revenue earned from these offerings does not show up in the YouTube advertising segment on Alphabet’s income statement but in the “Google Other” category.
It is frustrating to not see granular results for the entire YouTube division, but on the conference call, Alphabet’s management said that the growth in this category was driven by YouTube’s subscription offerings. The segment grew revenue 21% year over year to $8.33 billion — adding more than $1 billion in new quarterly revenue compared to 2022 — which indicates that YouTube’s overall revenue is growing quite quickly.
On top of this, Alphabet’s profit margin is starting to climb higher again. Operating margin was 28% in Q3, up from 25% in 2022. This was due to the major cost cuts and layoffs the company implemented over the past few quarters.
Those reductions led to $21 billion in consolidated operating earnings in the quarter, or $19.7 billion in net income when accounting for taxes. Over the last 12 months, Alphabet generated $66.7 billion in net earnings.
Should investors be worried about the cloud?
If Alphabet’s business is doing so well, why is the stock dropping? It all comes down to underwhelming growth in its cloud division, called Google Cloud Project (GCP).
GCP’s revenue “only” grew 22% year over year to $8.4 billion in the quarter, which was below analyst estimates. This was slower than Microsoft’s cloud division, which grew 28% in the quarter and is a larger business than GCP. Investors are concerned about these market share losses.
Slowing growth is a concern, but this doesn’t feel like a huge deal for Alphabet. The segment is still growing by 22% and has a huge opportunity ahead of it with new innovations in artificial intelligence (AI).
This was also only one period of meager growth. If it happens for multiple years, then maybe investors should start worrying. However, the cloud business can have lumpy growth due to customer contracts and the timing of payments. There’s no reason to panic over one weak quarter at GCP.
Is the stock cheap?
With the stock down 10%, Alphabet’s valuation has gotten cheaper. It currently trades at a price-to-earnings ratio (P/E) of 23.6, which is right around the market average. This isn’t dirt cheap, but investors need to remember a few things with Alphabet.
First, Alphabet is reinvesting a ton into its newer initiatives such as GCP and Waymo (its self-driving project). GCP only has an operating margin of 3% while competitors such as Amazon have a margin of 20% or more. This should equate over time.
Also, Alphabet has the potential to expand its profit margin over the next few years, based on these trends. Revenue should continue to grow quickly as more advertising transitions from analog to digital sources, which Alphabet dominates. Add it all together and I think Alphabet can be a solid buy at these prices.
— Brett Schafer
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Source: The Motley Fool